Kenya believe it? In 1943, Felice Benuzzi, an Italian civil servant who had been detained at a British POW camp at the foot of Mt. Kenya, and two others escaped after months of careful planning. The sole purpose of their breakout was to fulfill a quest to summit nearby Mt. Kenya. For months they made improvised mountaineering equipment in the POW camp as they tested escape plans. Upon escaping, they spent nearly three weeks hiking from the desert-like base to the frozen summit through jungles replete with big game. As avid mountaineers, Felice and his comrades found this expedition a splendid disruption to the tedium of prison life. Upon completion of their adventure, to the great astonishment of the camp commandant, they broke back into Camp 304. They were sentenced to twenty-eight days of solitary confinement which was commuted to seven days by the commandant to acknowledge their “sporting effort.” Felice, a lawyer by training, fully accepted the consequences of the risk he assumed both on the mountain and when he descended it.

Disruptive behavior like Felice’s is flavor of the month in the investment world as “pushing the envelope”, a visually peculiar metaphor, pervades private equity marketing presentations. This pushing, deemed to be virtuous by fiat, is seldom examined for its risk. Unrelated Business Taxable Income (UBTI) was a concept first pursued by the IRS when a group of wealthy alumni donated Mueller Macaroni Company to the NYU School of Law to help fund its operations. The IRS argued that making pasta was not part of the tax exempt activity at the law school. Congress agreed and deemed such income as UBTI (full disclosure: I am a large consumer of Mueller’s elbow macaroni). The practice of using credit lines by PE firms arose to bridge the short ten-day period between funding and receipt of a capital call. The IRS has blessed this practice, via private letter rulings, as not constituting UBTI. However, in recent years the credit lines have become IRR liposuction and are not repaid for much longer periods than a Kardashian marriage (72 days) as Funds keep balances outstanding for a year or more to enhance IRR. To what risks are the Funds exposed? The IRS can deem all income of the Fund associated with the debt financing taxable. Receipt of UBTI income may also make tax exempt investors subject to an IRS audit from which they had been exempt. Use of fee waivers can be pursued as another source of UBTI if the IRS has been led to examine a Fund which employs such leverage. Felice would be nodding at the acceptance of consequences. Contrary to the belief that the largest risk constituted by use of credit lines is having to purge the fund’s performance of any leverage benefit, the liability for UBTI could have a profound effect on both IRR and on net cash flow to investors. A rumor has been circulating that legislators are thinking of beginning the three year hold period for carried interest at the later of 1) when a Fund’s capital is drawn and invested, or 2) when a portfolio asset is purchased. This change may serve to adjust the risk-reward equation for some PE fund managers.